Five Interest Calculation Methods Important to the Lifeblood of Loans

Cindy Fisher | June 25, 2020

I remember being in Mr. Harrison’s 6th grade math class when he described interest to us. He said that if we had a 30-year mortgage and took all 30 years to pay off the loan, the real cost of the house would be triple what we paid for it. That was the day that sparked my interest in … interest.

Calculating interest may sound boring to some, but to financial professionals, it may be one of the most fascinating parts of the job.

GOLDPoint Systems has five different ways to calculate interest.

This blog post will attempt to help you understand the different calculation methods just a little better. They’re very well known in the financial industry, but sometimes it helps to have it explained in a way that makes it click. The Interest Calculation Method field is one of the most important fields in our whole system.

Interest Calculation Methods

Technically, GPS has 10 different Interest Calculation Methods, but five of them use the same calculation formula as the first five while allowing the Date Interest Paid to and Date Last Accrued to be more than one frequency behind the Due Date (whereas the first five calculation methods do not allow that). There are some other slight variations with the other five Interest Calculation Methods based on payment frequency (monthly, bi-weekly, etc.). We’ll discuss those in another blog post.

For this post, let’s focus on the following Interest Calculation Methods:

Code 1 – 365/365 days per year

If the Interest Calculation Method is set to “1 – 365/365”, monthly interest for the P/I Constant is calculated as follows:

Principal Balance amount as of last payment X Interest Rate ÷ 365 X days difference from last Due Date to current Due Date = the amount of payment that goes towards interest. The rest of the P/I Constant, after paying interest, goes to principal.

Example:

P/I Constant is $200.

Principal Balance as of last payment date = $25,000

Interest Rate = 5.75%

Last Due Date to this Due Date = 31 days

Interest Calculation Method = 1 – 365/365

 

Interest calculation:

25,000 X .0575 ÷ 365 X 31 = $122.09 ← This is the amount of interest paid from the P/I Constant.

200.00 – 122.09 = $77.91 ← This is the amount applied to principal from the P/I Constant.

 

Code 2 – 360/360 days per year

Code 2 considers every month as having 30 days. February and all the months with 31 days are considered 30-day months.

Principal Balance X Interest Rate ÷ 360 X 30 = Interest amount of payment

 

Example:

P/I Constant is $200.

Principal Balance as of last payment date = $25,000

Due Date to Due Date = 31 (but the calculation will use 30)

Interest Rate = 5.75%

 

Interest calculation:

25,000 X .0575 ÷ 360 X 30 = $119.79 ← This is the amount of interest paid from the P/I Constant.

200.00 – 119.79 = $80.21 ← This is the amount applied to principal from the P/I Constant.

 

Code 3 – 365/360 days per year

When using Code 3, the annual interest rate is divided by 360 to get the daily interest rate, and then multiplied by the number of days from last Due Date to current Due Date.

Principal Balance X Interest Rate ÷ 360 X days difference from last Due Date to current Due Date = Interest amount

Example:

P/I Constant is $200.

Principal Balance as of last payment date = $25,000

Interest Rate = 5.75%

Due Date to current Due Date = 31 days

 

Interest calculation:

25,000 X .0575 ÷ 360 X 31 = 123.78 ← This is the amount of interest paid from the P/I Constant.

200.00 – 123.78 = $76.22 ← This is the amount applied to principal from the P/I Constant.

 

Code 4 – 360/365 days per year

Simply put, Code 4 is like a 365-day simple daily calculation (Code 1) but looks like a 360-day calculation (Code 2) where each month has 30 days. Like Code 1, this method calculates interest accruals every day using a daily per diem interest amount.

Principal Balance X Interest Rate ÷ 365 X 30 (because every month is considered 30 days) = Interest

Example:

P/I Constant is $200.

Principal Balance as of last payment date = $25,000

Interest Rate = 5.75%

Every month is considered 30 days of interest (even though Due Date to Due Date is 31)

 

Interest calculation:

25,000 X .0575 ÷ 365 X 30 = 118.15 ← This is the amount of interest paid from the P/I Constant.

200.00 – 118.15 = $81.85 ← This is the amount applied to principal from the P/I Constant.

 

Code 5 – 366/366 days in a leap year

Code 5 is like a 365-day simple daily calculation (Code 1) but it also considers leap years. So, when there is a leap year, it calculates using 366, and when there isn’t a leap year, it calculates using 365.

Principal Balance X Interest Rate ÷ 366 (if leap year/365 if non-leap year) X number of days from Due Date to Due Date = Interest

Example:

P/I Constant is $200.

Principal Balance as of last payment date = $25,000

Interest Rate = 5.75%

Last Due Date is 02/15/2020 and next Due Date is 03/15/2020 (a leap year) = 29 days

 

Interest calculation:

25,000 X .0575 ÷ 366 X 29 = 113.90 ← This is the amount of interest paid from the P/I Constant.

200.00 – 113.90 = $86.10 ← This is the amount applied to principal from the P/I Constant.

 

Tip: Use the Amortization Schedule Screen to View Interest Details

Here’s a cool little trick that will bring home the differences in interest calculation in a more illustrious way.

  1. When in CIM GOLD, GPS’ loan servicing software, go to the Loans > Account Information > Amortization Schedule screen. Remember that this screen is more just for testing out how changing certain aspects of a loan will affect the loan. It doesn’t actually change the loan.
  2. When you are on that screen, try changing the Interest Calculation Method to another method, then click <Create Schedule>.
  3. Click on the Amortization Schedule tab and view the interest calculated each month. Right-click and print out the schedule for comparison.
  4. Go back to the Account Information tab and change the Interest Calculation Method to a different one, then click <Create Schedule> again.
  5. View the Amortization Schedule tab and print out that schedule.
  6. Compare the differences in monthly interest.

 

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Tags: calculations

Cindy Fisher | June 25, 2020

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